Global Economics

After Record Profits, Challenges for BP

The oil giant announced a 39% rise in 2008 profits, to $26 billion. But falling oil prices will take their toll on future strategy

The oil major BP may have announced another set of record profits yesterday, but behind the headline figures, the falling oil price is taking its toll on profitability and the chief executive's strategy to transform the company is not yet complete.

The company saw profits rise by a whopping 39 per cent to a record $25.6bn (£17.8bn) in 2008, with post-tax operating cashflow up 54 per cent to $25.6bn and $30.7bn-worth of investments over the period. Total dividends for the year were up 30 per cent in dollars and 40 per cent in sterling, making a total of $13.3bn distributed to shareholders over the year, including the $3bn share buyback programme halted last September in response to the uncertain economic environment.

But Tony Hayward, the chief executive, was explicit that the good times produced by last year's oil price boom are over for the foreseeable future, citing a $50 to $60 per barrel oil price for break even, compared with current prices around the $40 mark. "What is evidently different about 2009 is the economic environment, which means I don't see the record financial performance being repeated for some time," said Mr Hayward.

Performance in the fourth quarter gives an indication of what is to come. A one-off $700m tax-related loss by the company's Russian joint venture, TNK-BP, did not help matters. But the main culprit was the oil price. As it slid from last July's eye-watering $147 per barrel high, so too did BP's profits, dropping to $2.6bn on a replacement costs basis in the last three months of the year, down 24 per cent from the same period in 2007 and 74 per cent from the previous quarter.

Against such a background of unprecedented volatility, Mr Hayward has been pressing ahead with plans to rescue BP from a recent history beset by safety and performance issues. He remains bullish. "A year ago, we set out a plan to deliver safe and reliable operations, to restore revenues and to reduce the complexity and cost structure of BP. We've done exactly that," said Mr Hayward. "Our aim is to strike the right balance for shareholders, between current returns via dividend, sustained investment for long-term growth, and action on costs in the current challenging environment."

Mr Hayward has faced considerable tests since he took over as chief executive, in May 2007. His predecessor, Lord Browne of Madingley, wasconsidered a stellar performer until being tarnished by his untimely departure for lying to a High Court judge over details of his personal life. But under his leadership, BP was run as a federated series of fiefdoms, creating strong entrepreneurial spirit and the easy integration of assets acquired on a four-year buying spree. The downsides of that approach are now plain.

While Lord Browne was a world-class strategist, he was less good at operational detail, and his legacy was a company theoretically well-positioned but plagued by problems. The worst incident was the death of 15 employees in an explosion at the Texas City refinery in 2005. An oil spill in Alaska the following year, a fire at the company's Whiting plant in Indiana, and delays to the flagship Atlantis and Thunder Horse projects in the Gulf of Mexico, added to the tally of woe. And just a few months after he took over, Mr Hayward's prediction of "dreadful" quarterly results and the worst financial performance for 15 years were leaked to the press.

Twelve months on from the launch of its simplification and efficiency strategy, BP has made undoubted progress. The company reduced its 98,000-strong workforce by 3,000 last year, and will exceed the target to strip out 5,000 jobs by mid-2009. It has reduced the number of layers of management and eliminated nearly a fifth of its senior roles.

In the upstream business, production grew by 5 per cent last year and nine major projects got off the ground. Of great symbolic value was the start of production at Thunder Horse, in the Gulf of Mexico, in July. Development of the field took nearly three years longer than planned, with everything from welding problems to Hurricane Denis adding to delays, but the facility is now running at 200,000 barrels per day.

Another area of significant success in the last year is exploration. Mr Hayward yesterday trumpeted 2008 as "one of the best years in the past decade for exploration success", citing discoveries in Gulf of Mexico, Angola, Algeria, Egypt and the North Sea.

But the biggest improvements are in the refinery business, which has never been at BP's core. Underlying pre-tax profit in 2008 was nearly $650m, an improvement of more than $700m on the previous year's dire performance despite the weaker economic environment. In fact, compared with 2007, and adjusting for a lower margin and adverse foreign exchange rates, underlying profitability of the business has improved by more than $2bn. Not only is the refinery business running at 91 per cent capacity for the first time in more than three years, but, like at Thunder Horse, there have also been important symbolic victories—Texas City and Whiting have both returned to full economic capacity.

The trouble is that the unprecedented economic conditions are interfering with normal business. Richard Griffiths, an analyst at Evolution Securities, said: "So far Tony Hayward has been quite successful, but the problem is that the volatility in both the oil price and in refining margins has made it hard to measure."

The big question is, what happens next? Despite the endless gloomyeconomic data, BP is relatively upbeat about 2009. The company raised $5bn in debt last year and with only 21 per cent gearing, at the bottom of itstarget range, the company is not spooked by the difficulties of the credit crunch. It is sticking to plans for capital expenditure of $20-22bn this year, compared with $21.7bn in 2008, and will be keeping an eye open for potential acquisitions.

The key to the next 12 months will be to cut costs, particularly in the supply chain. Massive inflation in recent years has seen costs go up in double digits, and until the falling oil price feeds through to deflate commodity costs, the oil companies are being squeezed on both sides.

Over the longer term, all the oil companies face a challenge about how to respond to dwindling reserves and the world's attempts to wean itself off its environmentally destructive dependence on hydrocarbons.

The multinational oil giants are pouring money into their renewable divisions—BP's wind power capacity more than doubled to 432 megawatts in the fourth quarter, for example—and oil-rich sovereign wealth funds from Abu Dhabi to Norway are doing the same.

But there is a view amongst some in the City that such transformations are best left alone, and that the companies would be better returning capital to shareholders and gradually winding themselves down.

"You can probably find ample evidence in history of industries that, once they stepped outside their area of expertise, did not succeed," one analyst said.

"But we are still far away from that, and in the context of where the world's energy is and what the demand is, the only really viable option is still hydrocarbons."

Next in line: Who will follow Peter Sutherland?

As if plunging oil prices were not enough, BP's search for a new chairman is not going as smoothly as planned. The hunt for a suitablereplacement for Peter Sutherland, who will step down in March, has been running for some 18 months already. But when Paul Skinner, the Rio Tinto chairman, emerged as the favourite, the appointment was considered a done deal.

However, Rio is saddled with $40bn (£28bn) of debt after last year's purchase of Alcan, and its target to pay down $10bn this year is looking tricky. It admitted last week it is mulling a rights issue.

Not only does the debt fiasco reflect badly on Mr Skinner, but his board's blank refusal of a takeover offer from rival BHP Billiton also looks like poor judgment. Or so some BP shareholders think.

Whether the decision ultimately tips in his favour is likely to come down to the outcome of Rio's defensive manoeuvres. BP is tight-lipped, but Mr Skinner, who has resigned from Rio, may scrape through.